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Exclusive: JPMorgan settlement could cost bank closer to $9 billion

The headquarters of JP Morgan Chase & Co in New York is pictured in this September 19, 2013 file photo. REUTERS/Mike Segar/Files

By Aruna Viswanatha and David Henry

WASHINGTON/NEW YORK (Reuters) - JPMorgan Chase & Co's preliminary $13 billion mortgage settlement with the U.S. government could end up costing the bank closer to $9 billion after taxes, because the majority of the deal is expected to be tax deductible, two sources familiar with the matter said.

The deduction also means the government is getting less than it appears in this deal. Banks can often deduct legal settlements from their taxes, but cannot get tax benefits from penalties for violating laws.

JPMorgan and the U.S. government have been negotiating the tax treatment of the settlement. The outcome could have a dramatic impact on exactly what the deal ends up costing the bank, how it is perceived by the public and whether it becomes a model for resolving government investigations of mortgage deals at other banks.

JPMorgan is negotiating the settlement with a group of government agencies led by the Justice Department, and the deal is expected to include a $2 billion penalty, one source said.

But another $4 billion of the deal, which will go toward aid for struggling mortgage borrowers, is tax deductible, another person familiar with the negotiations said.

How the remaining $7 billion will be addressed remains unclear, but most, if not all, is likely to be deductible. Much of it is intended to compensate investors for shoddy mortgage securities they purchased from JPMorgan, as well as Bear Stearns and Washington Mutual, failing banks JPMorgan acquired during the financial crisis.

Those payments would usually be deductible as a normal business expense, as would payments by an appliance manufacturer to make good on defective washing machines, said tax expert Robert Willens.

If $11 billion is tax deductible, and assuming a 38 percent tax rate, the tax deduction could save JPMorgan as much as $4.18 billion, Willens said.

The government, however, could negotiate an exception and require that JPMorgan agree not to deduct some of those expenses from its taxable income, he said.

There is some precedent for such an exception. When Goldman Sachs agreed to pay $550 million in 2010 to resolve charges from the Securities and Exchange Commission, for example, the deal specifically forbade the bank from claiming a tax deduction on the portion of the settlement designed to compensate harmed investors.

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The public's reaction to the government's deal with JPMorgan could help determine whether it becomes a model for concluding investigations of other big banks.

The Obama administration has faced much criticism for bringing few marquee cases against Wall Street firms or executives for conduct that fueled the housing bubble and subsequent collapse.

The Justice Department set up a task force last year to probe that misconduct, and the JPMorgan action arose from that effort.

A point of tension in the negotiations, and a subject of public commentary, has been how much JPMorgan would have to pay for bad mortgage deals at Bear Stearns and Washington Mutual. JPMorgan bought those two banks with the encouragement of government officials who were trying to stem the financial crisis, but the bank has also generated big profits from the Bear and WaMu acquisitions since the crisis.

The $2 billion enforcement penalty would only apply to mortgage deals that JPMorgan did itself before the crisis, according to two people familiar with the matter.

There would be no penalties for mortgage bonds from Bear Stearns or Washington Mutual, just reimbursement for losses, such as those that government agencies have said they suffered, the people said. The two government mortgage finance agencies, Fannie Mae and Freddie Mac, said they bought mortgages from Bear Stearns and Washington Mutual that should never have been packaged into bonds.

The JPMorgan experience has triggered discussions among bank merger lawyers about how they can get indemnification clauses into future bailout deals.

JPMorgan reported a third-quarter loss, the first under CEO Jamie Dimon, on October 11 as it recorded a $7.2 billion after-tax expense to add to its legal reserves in anticipation of a settlement with the government. The pre-tax expense was $9.15 billion, the company said. That addition to its reserves was not only for the mortgage probes, and includes other legal matters.

The company did not say how much of its previously established legal reserves might have been earmarked for the mortgage cases government agencies are investigating. After the additions, JPMorgan said its legal reserves stood at $23 billion at the end of the quarter.

(Reporting by Aruna Viswanatha in Washington and David Henry in New York; Editing by Dan Wilchins, Tim Dobbyn and Dan Grebler)